Zombie alert! Fed and ECB's next moves could expose the living dead

When the history of the global economy post-crisis is written, this week might be seen to have provided a significant moment - and one not necessarily universally positive.

At face value, the US Federal Reserve board's decision to raise the federal funds rate by 25 basis points -- the second increase this year and the sixth since late 2015 – is an endorsement of the strength of the US economy and the progress in normalising US monetary policy.

The Fed flagged another rate rise later this year and, by a slender majority, indicated there might even be a fourth. With US GDP growth pushing towards 3 per cent, the unemployment rate falling below 4 per cent and inflation around 2 per cent it signalled the trajectory of rates is steepening.

Has the Fed fully factored in the "sugar hit" from Trump's big spender policies?Credit:AP

Trump's sugar hit

Advertisement

There is a question, however, if the US central bank is fully factoring in the impact of the "sugar hit" to the economy coming from Trump’s $US1.5 trillion ($1.9 trillion) worth of tax cuts and $US300 billion increase in spending.

The risk for the US is that the Fed is forced to raise rates faster and further than it envisages even as its pre-programmed winding down of a balance sheet swollen by its $US3.6 trillion of bond and mortgage-buying in the post-crisis period sucks liquidity out of the economy.

Loading

The increased borrowing requirement generated by Trump’s debt and deficit-expanding policies will also further step up pressure on market rates.

The US rate hikes are already sending threatening ripples through other economies as capital flows towards the US and the US dollar strengthens.

Argentina has sought assistance from the International Monetary Fund. Turkey, Indonesia, the Philippines, Brazil, India and Pakistan have all been forced to raise their rates to defend their currencies.

US monetary policy and its rate structure is setting it apart from most of the rest of the developed world in a fashion that will impose pressure on economies that may be more fragile than they might previously have been regarded in an ultra-low global rates environment.

All eyes on Latvia

Enter the European Central Bank - the "other" major central bank - which may make this week even more significant for the world economy at a meeting in Riga, Latvia, overnight.

The ECB, which presiding over negative official rates and its version of the Fed’s "quantitative easing" - bond purchases that have seen it buy €2.5 trillion ($3.7 trillion) of government and corporate bonds in only three years -, isn’t expected to raise rates or further reduce a program that peaked at €80 billion of assets purchases a month in 2016, and is now running at a monthly €30 billion.

But it's widely expected that - if not at this meeting, then next month - the ECB will set out a timetable for when it ends its quantitative easing program, which may be as early as the end of this year.

And while the ECB is a long way behind the Fed in starting to normalise its monetary policies, some withdrawal of stimulus could have disproportionately large effects.

The ECB has acquired 22 per cent of the European Union governments’ debts. It owns more than 29 per cent of Germany’s sovereign debt and about 17 per cent of Italy’s. It has also bought €157 billion of eurozone corporate debt.

Its policies have not just lowered borrowing costs in the eurozone, but in effect socialised them. The end of its asset purchases could see spreads between the rates on bond issues between strong and weak economies and companies blow out.

Rise of the zombies

The OECD and the Bank for International Settlements (BIS) have published papers in recent years discussing "zombie" companies – established businesses whose earnings don’t cover their interest costs but which have been kept alive by post-crisis policies.

Last year, the BIS estimated the proportion of zombies among listed companies in 14 OECD economies had doubled, to 10 per cent, since the crisis. The OECD nominated Greece, Italy and Spain as having high proportions of zombies.

But there may also be zombie economies.

There may be "zombie" economies, kept afloat by the major central banks' cheap-money policies after the GFC. What happens when those end?

A consequence of the policies pursued by the Fed, the ECB and the Bank of Japan since 2008 has been a significant increase in global debt – at government, corporate and household levels – as ultra-low rates and torrents of liquidity ignited a global borrowing binge.

There was a particular appetite in developing economies for US dollar-denominated debt, which became abundant and cheap as US investors were incentivised and enabled by the Fed to take on more risk in return for higher returns.

The US rate rises, combined with a stronger US dollar, are now putting a squeeze on emerging market economies.

If the ECB were to also start unwinding its stimulus, economies and banking systems within the weaker southern regions of the eurozone would come under intense pressure, along with more debt-laden companies.

It shouldn’t come as a surprise to anyone that after a decade of unprecedented policy interventions in economies and markets there could be unintended consequences that emerge as those policies are wound back.

While it might take some time before those consequences are fully visible, it's clear that at some point in the not-too-distant future they will be if the Fed continues on its current projected path and the ECB moves as expected this year.

Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.